AP_Krugman_Textbook

There’s another important contrast between supply shocks and demand shocks. As

we’ve seen, monetary policy and fiscal policy enable the government to shift the AD

curve, meaning that governments are in a position to create the kinds of shocks shown

in Figure 19.2. It’s much harder for governments to shift the AScurve. Are there good

policy reasons to shift the ADcurve? We’ll turn to that question soon. First, however,

let’s look at the difference between short -run macroeconomic equilibrium and long -

run macroeconomic equilibrium.

Long-Run Macroeconomic Equilibrium

Figure 19.4 combines the aggregate demand curve with both the short -run and long -

run aggregate supply curves. The aggregate demand curve, AD,crosses the short -run

aggregate supply curve, SRAS,atELR.Here we assume that enough time has elapsed

that the economy is also on the long -run aggregate supply curve, LRAS.As a result, ELR

is at the intersection of all three curves—SRAS, LRAS,andAD.So short -run equilibrium

aggregate output is equal to potential output, YP.Such a situation, in which the point

of short -run macroeconomic equilibrium is on the long -run aggregate supply curve, is

known as long -run macroeconomic equilibrium.

To see the significance of long -run macroeconomic equilibrium, let’s consider

what happens if a demand shock moves the economy away from long -run macroeco-

nomic equilibrium. In Figure 19.5, we assume that the initial aggregate demand curve

isAD 1 and the initial short -run aggregate supply curve is SRAS 1. So the initial macro-

economic equilibrium is at E 1 , which lies on the long -run aggregate supply curve,

LRAS.The economy, then, starts from a point of short -run and long -run macroeco-

nomic equilibrium, and short -run equilibrium aggregate output equals potential out-

put at Y 1.

Now suppose that for some reason—such as a sudden worsening of business and

consumer expectations—aggregate demand falls and the aggregate demand curve

shifts leftward to AD 2. This results in a lower equilibrium aggregate price level at P 2

and a lower equilibrium aggregate output level at Y 2 as the economy settles in the

short run at E 2. The short -run effect of such a fall in aggregate demand is what the

194 section 4 National Income and Price Determination

figure 19.4

Long -Run Macroeconomic

Equilibrium

Here the point of short -run macroeco-

nomic equilibrium also lies on the long -

run aggregate supply curve, LRAS.As a

result, short -run equilibrium aggregate

output is equal to potential output, YP. The

economy is in long -run macroeconomic

equilibrium at ELR.

YP

PE

SRAS

LRAS

AD

Long-run

macroeconomic

equilibrium

Potential

output

Real GDP

Aggregate

price

level

ELR

The economy is in long -run
macroeconomic equilibriumwhen the
point of short -run macroeconomic equilibrium
is on the long -run aggregate supply curve.